1 Chapter 23 Mutual Fund Operations Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2 Chapter Outline Background on mutual funds Stock mutual fund categories Bond fund categories Growth and size of mutual funds Performance of mutual funds Mutual fund scandals

3 Chapter Outline (cont’d) Money market funds Hedge funds Real estate investment trusts Interaction with other financial institutions Use of financial markets Globalization through mutual funds

4 Background on Mutual Funds Mutual funds:  Serve as a financial intermediary by pooling investments by individual investors and using the funds to accommodate financing needs by governments and corporations in the primary market  Frequently invest in securities in the secondary market  Provide an important service for individuals who wish to invest funds and diversify  Offer liquidity if they are willing to repurchase an investor’s shares upon request  Offer various different services, such as transfers between funds and check-writing privileges

5 Background on Mutual Funds (cont’d) A mutual fund hires portfolio managers to invest in a portfolio of securities that satisfies the desires of investors  The portfolio composition is adjusted in response to changing economic conditions The board of directors:  Monitors management  Establishes procedures  Ensures that the fund is properly serving its shareholders Under new SEC rules, a majority of board members must be outsiders

6 Types of funds  Open-end funds: Are open to investment from investors at any time Allow investors to purchase or redeem shares at any time Have a constantly changing number of shares Maintain some cash in case redemptions exceed investments Consist of many different categories to satisfy investors’ investment needs Background on Mutual Funds (cont’d)

7 Types of funds (cont’d)  Closed-end funds: Do not repurchase shares they sell Require investors to sell the shares on a stock exchange Have a constant number of outstanding shares Have an asset size that is about 1/40 th of the asset size of open-end funds Focus primarily on bonds and other debt securities Background on Mutual Funds (cont’d)

8 Types of funds (cont’d)  Exchange-traded funds: Are designed to mimic particular stock indexes and are traded on a stock exchange Differ from open-end funds in that their shares are traded on an exchange, and their share price changes throughout the day Consist of a fixed number of shares Are not actively managed Have become very popular in recent years Typically do not have capital gains and losses that must be distributed to shareholders Background on Mutual Funds (cont’d)

9 Types of funds (cont’d)  Hedge funds: Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Differ from open-end funds because:  They require a much larger initial investment  They may not always accept additional investments or accommodate redemption  They are unregulated and provide very limited information to prospective investors  They invest in a wide variety of investments to achieve high returns Background on Mutual Funds (cont’d)

10 Comparison to depository institutions  Mutual funds repackage the proceeds from individuals to make various types of investments  Investing in mutual funds represents partial ownership Investors share the gains or losses generated by the fund Background on Mutual Funds (cont’d)

11 Information contained in a prospectus  The minimum amount of investment required  The investment objective  The return on the fund over the past year, the past three years, and the past five years  The exposure of the fund to various types of risk  The services offered by the fund  The fees incurred by the find that are passed on to investors Background on Mutual Funds (cont’d)

12 Estimating the net asset value  The net asset value (NAV) of a mutual fund indicates the value per share Estimated each day by determining the market value of all securities comprising the fund, adding interest or dividends, and subtracting expenses, then dividing by the number of shares outstanding Background on Mutual Funds (cont’d)

13 Computing the NAV Philly Mutual Fund has 50 million shares issued to its investors. It used the proceeds to buy stock in 100 different firms. These shares have a market value of $100 million. In addition, Philly incurred $7,000 in expenses today and collected interest and dividends totaling $5,000. What is the net asset value per share?

14 Distributions to shareholders  Mutual funds generate returns to shareholders in three ways: They pass on earned income as dividend payments They distribute capital gains resulting from the sale of securities within the fund Mutual fund share price appreciation Mutual fund classifications  Stock mutual funds, bond mutual funds, or money market mutual funds (see next slide) Background on Mutual Funds (cont’d)

15 Background on Mutual Funds (cont’d) Distribution of Investment in Mutual Funds

16 Expenses incurred by shareholders  Mutual funds pass their expenses on to their shareholders  Expenses can be compared among mutual funds by comparing the expense ratio Equal to annual expenses per share divided by the NAV The higher the expense ratio, the lower the return for a given level of performance Mutual funds with lower expense ratios tend to outperform others with similar objectives Background on Mutual Funds (cont’d)

17 Expenses incurred by shareholders (cont’d)  Expenses include: Compensation to the portfolio managers and other employees Record-keeping and clerical fees Marketing fees Background on Mutual Funds (cont’d)

18 Sales load  Load funds have a sales charge Promoted by brokerage firms who earn a sales charge between 3 and 8.5 percent Investors pay the sales charge through the difference between the bid and ask prices of the load fund Front-end load versus back-end load Background on Mutual Funds (cont’d)

19 Sales load (cont’d)  No-load funds are promoted strictly by the mutual fund of concern Preferred by investors who feel capable of making their own investment decisions Recently, some small no-load funds have become load funds because they could not attract sufficient investors Background on Mutual Funds (cont’d)

20 Corporate control by mutual funds  Large mutual funds can exert control over the management of firms because they are commonly a firm’s largest shareholders e.g., Fidelity is the largest shareholder of more than 700 firms  Portfolio managers of many funds serve on the board of directors of various firms  Many firms discuss any major policy changes with analysts and portfolio managers of funds to convince them that the change will have a favorable effect Background on Mutual Funds (cont’d)

21 Stock Mutual Fund Categories Growth funds are composed of stocks of maturing companies that are expected to grow at a high rate  The primary objective is to increase investment value Capital appreciation funds are composed of stocks that have high growth potential but may be unproven  Suited to investors who are willing to risk a possible loss in value Growth and income funds provide potential for capital appreciation with some stability in income

22 Stock Mutual Fund Categories (cont’d) International and global funds  International funds invest in foreign securities  Returns on international funds are affected by the foreign companies’ stock prices and the movements of the currencies that denominate the stocks  Global funds include some U.S. stocks

23 Stock Mutual Fund Categories (cont’d) Specialty funds focus on a group of companies sharing a particular characteristic  e.g., energy or banking Index funds are designed to match the performance of an existing stock index  e.g., Vanguard 500 Multifund funds invest in a portfolio of different mutual funds to achieve more diversification

24 Bond Fund Categories Income funds are composed of bonds that offer periodic coupon payments and vary in exposure to risk  Corporate bonds are subject to credit risk, Treasury bonds are not  Bonds backed by government agencies are less risky than corporate bonds Tax-free funds contain municipal bonds  Allows investors in high tax-brackets to avoid taxes while maintaining a low degree of credit risk

25 Bond Fund Categories (cont’d) High-yield (junk) bond funds consist of at least two- thirds of bonds rated below Baa by Moody’s or BBB by S&P International and global bond funds  International funds contain bonds issued by corporations or governments based in other countries  Global bond funds contain U.S. as well as foreign bonds  Foreign bonds are subject to credit risk, interest rate risk, and exchange rate risk

26 Performance of Mutual Funds Performance of stock mutual funds  The change in performance of an open-end mutual fund can be modeled as:  Change in market conditions A mutual fund’s performance is closely related to market conditions The mutual fund’s beta can be used to measure the sensitivity of the fund’s exposure to market conditions

27 Performance of Mutual Funds (cont’d) Performance of bond mutual funds  The change in performance of an open-end mutual fund can be modeled as:  Change in the risk-free rate Bond prices are inversely related to changes in the risk-free interest rate Bond funds focused on longer maturities are more exposed to interest rate changes

28 Performance of Mutual Funds (cont’d) Performance of bond mutual funds (cont’d)  Change in the risk premium Bond prices decline in response to an increase in the risk premium Poor economic conditions tend to increase the risk premium  Change in management abilities The performance of specific bond classifications varies due to differences in managers’ abilities An efficient fund has low expenses and high returns

29 Performance of Mutual Funds (cont’d) Performance of closed-end bond funds  Driven by the same factors as open-end bond funds  Closed-end bond funds are also affected by a change in their premium or discount Performance from diversifying among mutual funds  The performance of any given mutual fund may be primarily driven by a single economic factor e.g., growth funds are highly dependent on the stock market’s performance  Diversification across different mutual funds reduces susceptibility to any particular type of risk

30 Money Market Funds Money market funds:  Are portfolios of money market instruments constructed and managed by investment companies  Allow investors to participate for as little as $1,000  Usually allow check-writing privileges  Send periodic account statements to their shareholders  Send shareholders periodic updates on any changes in the asset portfolio composition  Sell some of their assets when redemptions exceed sales

31 Money Market Funds (cont’d) Risk of money market funds  Credit risk is low, with the exception of commercial paper defaults  Money market securities are not too sensitive to movements in market interest rates  Expected returns on MMFs are low because of: Low credit risk Low interest rate risk Consistently positive returns

32 Hedge Funds Sell shares to wealthy individuals and financial institutions and use the proceeds to invest in securities Have historically been unregulated but are not allowed to advertise Are usually organized as limited partnerships May allow investors to withdraw their investments but require advance notice of 30 days or more Often invest in derivative securities, sell short, or use borrowed funds along with equity investments Strive for high returns but also have a very high degree of risk